Incremental Information Content of the Change in the Percent of Production Added to Inventory

Posted: 16 Oct 1996

See all articles by James J. Jiambalvo

James J. Jiambalvo

University of Washington - Michael G. Foster School of Business

Eric W. Noreen

University of Washington

Terry J. Shevlin

University of California-Irvine

Abstract

Manufacturing firms can manipulate income by producing in excess of the quantity needed to meet current period demand, thereby allocating part of current period fixed manufacturing overhead costs from cost of goods sold to inventory. Since it is subject to manipulation, the component of earnings due to producing in excess of sales may be of lower quality than the remaining component of earnings. We investigate this possibility using a regression of security returns on unexpected income and an estimate of the change in percent of production added to inventory (CPAI). An analytical model indicates that CPAI determines the "earnings surprise" subject to manipulation by overproducing. Assuming the market recognizes this, the coefficient on CPAI should be negative since this low quality component must be deducted from the total "good news" conveyed by the change in reported earnings. Alternatively, CPAI may convey good or bad news to the market that is unrelated to the manipulation of current period earnings. Firms may increase the percent of production added to inventory in anticipation of high levels of future sales. In this case, the estimated coefficient on CPAI should be positive. Or if the increase in the percent of production added to inventory reflects anticipation of a strike or an unexpected downturn in current sales, the estimated coefficient should be negative. Cross-sectional tests using a large sample of manufacturing firms indicate a significant positive relation between security returns and CPAI. This is consistent with market participants viewing CPAI as a leading indicator of firm performance. While the results are most supportive of CPAI conveying good news, there is some evidence that CPAI is used by managers to smooth earnings and, for firms classified as smoothing earnings, there is weak evidence that the component of earnings related to CPAI is viewed by market participants to be of lower quality.

JEL Classification: M41, M11, L60, G12

Suggested Citation

Jiambalvo, James J. and Noreen, Eric W. and Shevlin, Terry J., Incremental Information Content of the Change in the Percent of Production Added to Inventory. Available at SSRN: https://ssrn.com/abstract=2774

James J. Jiambalvo (Contact Author)

University of Washington - Michael G. Foster School of Business ( email )

Box 353200
Seattle, WA 98195-3200
United States
206-543-9132 (Phone)
206-685-9392 (Fax)

Eric W. Noreen

University of Washington ( email )

231 Mackenzie Hall
Seattle, WA 98195
United States
206-543-4869 (Phone)
206-685-9392 (Fax)

Terry J. Shevlin

University of California-Irvine ( email )

Paul Merage School of Business
Irvine, CA California 92697-3125
United States
2065509891 (Phone)

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